Cleary, Gottlieb, Steen & Hamilton
April 28, 2000
Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: Release Nos. 33-7787; 34-42259; File No. S7-31-99; Proposed
Regulation FD and Selective Disclosure
Dear Mr. Katz:
We appreciate the opportunity to submit this letter responding to your request for comments on proposed Regulation FD regarding selective disclosure of material nonpublic information.1
We agree with you that "[I]nformation is the lifeblood of our securities markets." We also support the goal of broad and timely dissemination of information to investors. We do not, however, see in the Release sufficient evidence of selective disclosure or "unfair" access to information to justify the dramatic departure from existing disclosure principles that proposed Regulation FD would represent if adopted. Furthermore, we believe that if further study and evaluation were to demonstrate a level of unfairness that justified a departure from current principles, the remedy should be targeted at the vice -- trading on material nonpublic information -- and not at non-culpable issuer disclosure. Finally, we believe that the chances are extremely high that the adoption of Regulation FD will chill issuer disclosure and therefore produce results at odds with your objective -- increased broad disclosure of information. We therefore respectfully oppose the adoption of Regulation FD.
We would elaborate on our views as follows:
The evidence presented in the Release regarding trading activity at the time of analysts' meetings or conference calls seems largely beside the point. These calls are increasingly open to media and investors generally. Continuation of this trend towards public access, which we support and would expect with or without Regulation FD, will not reduce unusual trading activity or volatility (or their impact on those who do not trade) at these times.
In the absence of more systematic and convincing evidence, we would urge you not to adopt Regulation FD as proposed but rather seek to determine by a "blue ribbon" study or other means what issuer disclosure practices are and should be, and at the same time use your unique position to persuade issuers to use available and emerging technology and take other steps to increase public disclosure.
Except for specified periodic disclosures and disclosures tied to specified securities activities, such as public offerings and tender offers, regulation of disclosure has historically been tied to abusive trading practices, particularly insider trading. Equal access to information by itself is not a stated objective of the securities laws; indeed, the Dirks and Chiarella cases suggest to the contrary.2 Where the inequality of access to information has been deemed "unfair" and persons with the unfair access have benefited, you and the courts have relied on various theories of insider trading law to right the imbalance.
Regulation FD would work a dramatic and we think dangerous departure from the current system. It would transfer the regulatory focus from the activity that is viewed as harmful -- trading with unfair informational advantage -- to non-culpable and even salutary disclosure by an issuer of accurate information.
Because Regulation FD would extend beyond securities-related activities, its reach is troubling and will we believe prove unworkable. Issuers acting in the ordinary course of their commercial activity regularly communicate information to customers, suppliers, outside sales forces, unions, regulators and other parties that are unrelated to securities activities or investors. None of the people to whom issuers communicate in these contexts are in positions of trust and confidence or have explicit confidentiality agreements. We believe that it is not good policy to require issuers to make materiality judgments in connection with these kinds of communications and that a regulation imposing that requirement, such as proposed Regulation FD, would be unworkable in practice. For you to require confidentiality agreements in such circumstances would represent an unprecedented and, we think, unwarranted intrusion into ordinary commercial matters.
Proposed Regulation FD is overbroad in its attempt to regulate non-culpable issuer disclosure even in securities-related areas. The proposal is certainly intended to cover disclosure to a group of securities analysts of information that may be material. This is the case even if the analysts intend only to evaluate the information and disseminate it broadly such that no trading on material nonpublic information would occur until this broad dissemination. We believe that there is no justification for threatening issuers with enforcement actions in these circumstances, as Regulation FD would do.
We also believe that Regulation FD, by imposing the risk of enforcement actions and significant penalties for issuer communications, would chill the flow of information to the market. In a number of circumstances, which you should not underestimate, issuers will choose not to disclose information that they disclose today, and counsel will certainly advise issuers to provide less disclosure in a variety of contexts. Under Regulation FD issuers would be faced with potential enforcement actions against "reckless" selective disclosure of information that you determine to be "material." Those determinations would be made with the benefit of hindsight, and in an atmosphere in which the Commission staff has declared that in increasingly volatile markets information that turns out to affect stock prices may be "material"3 and in which the concept of the "reasonable" investor that is the touchstone of materiality determinations is becoming increasingly elusive. In our judgment less disclosure of information to the securities markets will be the result.
We would also point out that there would almost certainly be a reduction in certain types of disclosures as a result of Regulation FD. For example, while conference calls to discuss quarterly results can be (and are being) opened to the media and investors generally, it is probably impractical to make other opportunities, such as plant visits, open to all. Securities industry participants would argue, we believe, that such visits are intended as opportunities to obtain valuable background and not to receive material information. If Regulation FD is adopted, however, issuers would be less willing to provide these opportunities because what would have been a harmless (and if necessary correctable) disclosure of material information during such a visit would become a potential legal violation with serious consequences.
Proposed Regulation FD results from your concerns about the possibility of selective disclosure resulting in abusive trading by persons whom you perceive as having an unfair informational advantage. Moreover, you are concerned that the current prohibitions on insider trading do not reach this activity. We believe that if in fact the evidence supports these concerns, you should engage in rule-making and, if necessary, propose legislation that addresses the abuse. We do not believe that you should address the matter indirectly by broadly regulating categories of issuer disclosure that are non-culpable. Instead, the focus should be on trading with an unfair informational advantage; this is the approach taken in other jurisdictions, such as the United Kingdom, where trading based on market sensitive information is restricted. Any regulation of issuer disclosure should be tied closely to abusive trading activities and should not be based merely on the materiality of information disclosed.
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If, despite our deep concerns outlined above, you seek to adopt Regulation FD in the form proposed, we would urge you to implement the suggestions set out below in order to reduce the negative consequences of the Regulation and make it more workable.
I. Issues Relating to Materiality
As noted above, a critical element in proposed Regulation FD is the determination of what constitutes "material" information. The proposed Regulation does not define "material," but instead relies on formulations developed by courts over the years, formulations that are by their very nature imprecise.4 Issuers and other market participants have voiced concerns that as a result of this imprecision Regulation FD would "chill" corporate disclosures to analysts, investors and the media. In the Release you too recognize that materiality judgments can be difficult, and that corporate officials may in response to the Regulation become more cautious in communicating with analysts or selected investors, or feel compelled to consult with counsel more frequently about their ability to respond to questions from analysts and investors. One practical issue under Regulation FD would involve responses to questions requiring instant judgments regarding materiality in settings, such as analysts' meetings or calls, that are not "public" under the standards of the proposed Regulation. In these circumstances, corporate officials may speak less often out of fear of an after-the-fact assessment that disclosed information was material. The result would be less disclosure, particularly less of the spontaneous candid disclosure that is not found in more formal disclosure documents such as press releases and Form 8-K filings.
A. SAB 99 and Definition of Materiality
Issuers are concerned that Regulation FD would expose them to increased risk of liability in connection with disclosure to analysts, investors and the media. You have added to the potential chill on disclosure by including in the Release a reference to the definition of materiality contained in SAB 99. We, along with many issuers, believe that the "qualitative" approach to materiality that was adopted in SAB 99 in the context of review of financial statements by independent auditors is broader than the definition of materiality set forth in the court cases cited above. We are concerned that the application of the SAB 99 standard of materiality to assessments of materiality in connection with Regulation FD will result in even greater hesitance on the part of corporate officials to disclose information to analysts, investors and the media.
To address this issue, we recommend that you clarify, either in Regulation FD itself or in the adopting release that accompanies any final Regulation, that the term materiality as used in Regulation FD has the meaning given to it by the courts in cases such as Basic v. Levinson, TSC Industries v. Northway and SEC v. Texas Gulf Sulphur, and that the discussion of materiality in SAB 99 does not apply outside the financial statement context of SAB 99.
B. Definition of Intentional
Concerns regarding the imprecise nature of the definition of materiality are compounded by the subjective element that has been introduced into Regulation FD through the definition of "intentional" in proposed Rule 101. Under the Rule, selective disclosure of material nonpublic information would be "intentional" (and thus require simultaneous public disclosure) if the individual making the disclosure knew, or was reckless in not knowing, that the information being communicated was material and nonpublic.
Congress has in recent years acted to promote issuer disclosure of information, particularly forward-looking information, to the marketplace. As part of the Private Securities Litigation Reform Act of 1995, Congress added a safe harbor for forward-looking information to the Securities Exchange Act of 1934 (the "Exchange Act"). Section 21E of the Exchange Act provides a safe harbor for disclosures of forward-looking information unless a plaintiff can prove that the person making the statement did so with "actual knowledge" that the statement was false or misleading. The use of an objective standard in Section 21E has provided comfort to issuers that their forward-looking statements will not be subject to after-the-fact reevaluations, and has thereby contributed to an increase in the disclosure of forward-looking information. "Recklessness" is tied to the outer limits of scienter in the fraud context and has no relevance or necessary applicability to the standards that should apply in the proposed selective disclosure rules (which have nothing to do with fraud). The more objective standard that Congress used in 1995 is much more suitable. Although materiality is a matter less susceptible to objective determination than truth or falsity, we believe that a more objective standard than you propose would at least provide issuers with greater comfort in the context of Regulation FD that their judgments as to materiality would not be subject to after-the-fact reassessments. We therefore suggest that you modify the definition of "intentional" in Rule 101 to read as follows:
(a) "Intentional. A selective disclosure of material nonpublic information is "intentional" when the individual making the disclosure had actual knowledge prior to the disclosure that he or she would be communicating information that was material and nonpublic."
II. Application to Non-U.S. Issuers
As proposed, Regulation FD would apply to non-U.S. issuers that are required to file periodic reports with the Commission. This would result in a significant increase in the level of intrusion of the U.S. securities laws in the disclosure practices and corporate activities of non-U.S. issuers, and would represent a dramatic shift in the analytical framework for periodic disclosure requirements applicable to non-U.S. issuers. We believe this shift is not appropriate because it is inconsistent with the long-standing, comity-based approach you have applied to non-U.S. issuers that participate in the U.S. capital markets.
A. Foreign Private Issuers
Currently, foreign private issuers that are required to file periodic reports under the Exchange Act have an annual obligation to file a Form 20-F. Their only additional reporting obligation is to file a Form 6-K with respect to any material information provided to shareholders, regulators or stock exchanges pursuant to their home jurisdiction requirements. As a result, U.S. filing requirements beyond the annual Form 20-F are effectively determined by reference to home jurisdiction requirements.
Under Regulation FD a reporting foreign private issuer that discloses material (determined under U.S. standards) nonpublic information anywhere in the world would trigger the Regulation's public disclosure requirements without regard to its home jurisdiction requirements. In fact, to the extent that public disclosure pursuant to Regulation FD would trigger home jurisdiction disclosure, application of Regulation FD could result in home jurisdiction requirements being determined by reference to U.S. requirements rather than vice versa. Regulation FD's effective imposition of U.S. disclosure standards on non-U.S. issuers' home jurisdiction conduct would significantly increase their compliance burdens.
Over the years less rigid disclosure requirements have been applied to non-U.S. issuers as a matter of policy in order not to impose burdens inconsistent with their home jurisdiction requirements. This policy has successfully encouraged foreign private issuers to access the U.S. capital markets and allowed U.S. investors a broader array of investment opportunities. Foreign private issuers have been exempted from the requirements to file proxy statements and quarterly and current reports under the Exchange Act, and their securities are not subject to Section 16(a) reporting or Section 16(b) short-swing profit liability. Just last year, you reaffirmed your commitment to flexibility with respect to foreign private issuers, adopting a revised Form 20-F pursuant to the disclosure standards adopted by the International Organization of Securities Commissions ("IOSCO").5 At that time, you stated that the goal of many of your initiatives for foreign issuers was to reduce the barriers to cross-border offerings and listings in the United States. The proposal to apply Regulation FD to foreign private issuers contradicts and reverses the accommodations that you have made to these issuers in the past. It would also significantly increase the level of intrusion of the U.S. securities laws in the affairs of non-U.S. issuers. The usual and customary activities of these issuers with local media, unions and labor, customers and suppliers, strategic investors and others could be dramatically affected. If you feel the need to address this issue with respect to foreign private issuers, we believe it should be done under the aegis of IOSCO.
B. Foreign Governmental Issuers
Foreign governmental issuers with listed securities, which are thus registered under Section 12 of the Exchange Act, would be subject to Regulation FD as proposed. It would also appear based on proposed Rule 101(b) that foreign governmental issuers that file annual reports on Form 18-K voluntarily, generally to facilitate updating of their shelf registration statements, would be subject to the Regulation. The arguments against applying Regulation FD to foreign private issuers apply with even greater force in the case of foreign governmental issuers, and we assume you did not intend the Regulation to apply to foreign governments.
III. Persons Outside the Issuer
We believe the meaning of the phrase "persons outside the issuer" as set forth in proposed Rule 100(b) requires modification to make it consistent with market practice. Rule 100(b) states that Regulation FD would not apply to disclosures to persons in two categories: those who are bound by duties of trust or confidence not to disclose the information or use the information for trading; and those who have expressly agreed to maintain disclosed information in confidence. Although this approach appropriately recognizes that issuers may share material nonpublic information with outsiders they reasonably expect to maintain confidentiality, the narrowness of the second category, insofar as it would require an express confidentiality agreement, would force significant changes to current market practice in the context of preliminary merger and acquisition discussions and private offerings of securities.
Under current practice, confidentiality agreements are generally signed in connection with merger and acquisition transactions only at the time confidential business information is exchanged. Because of the inherent uncertainty of what information is material, the proposed Regulation could be interpreted (although we believe incorrectly) to require that a confidentiality agreement be signed in connection with preliminary merger or acquisition discussions that occur prior to the exchange of confidential business information. Such a requirement would pose practical obstacles to preliminary merger and acquisition discussions, forcing the participants to negotiate a confidentiality agreement before any discussion on the substance of the transaction even begins.
Issuers sometimes disclose material nonpublic information to investors in connection with Rule 144A and other private offerings of securities. Although the disclosure documents in these transactions often contain confidentiality legends, potential investors generally do not expressly agree, either with the issuer or the placement agent, to maintain the confidentiality of the information. (In addition, we believe that in some cases, such as ERISA plans, investors are legally restricted in their ability to sign such agreements.) The requirement to obtain an express confidentiality agreement is of particular concern in this context, since a failure to obtain such an agreement would require public disclosure in accordance with Regulation FD at the time of the private offering. Public disclosure at such a time could, of course, result in a loss of the availability of the private placement exemption from registration. We would also observe that we are unaware of any information, cited by you or otherwise, that disclosure in the context of private offerings has resulted in abusive trading on material nonpublic information.
In the two situations described above, the issuer would have an expectation that the recipient of the material nonpublic information would maintain its confidentiality, and would therefore not consider it necessary to obtain an express confidentiality agreement. We believe any rules that are adopted should allow issuers to selectively disclose information in reliance on such an expectation without requiring an express confidentiality agreement. We therefore propose that you modify the language of Rule 100(b) to read as follows:
"(b) Paragraph (a) of this section shall not apply when a disclosure is made (1) to a person who owes a duty of trust or confidence to the issuer (including, for example, an outside consultant such as an attorney, investment banker or accountant) or (2) to a person whom the issuer or person acting on behalf of the issuer reasonably expects will maintain the confidentiality of the disclosed information."
IV. Persons Acting on behalf of the Issuer
Regulation FD would apply to any disclosure of material nonpublic information by any person acting on behalf of an issuer. You state in the Release that the Regulation is intended to apply only to "the disclosures of company officials, employees, or agents who are properly authorized or designated to speak to the media, the analyst community, and/or investors." Proposed Rule 101(c), however, defines a person acting on behalf of an issuer much more broadly to include any officer, director, employee or agent who discloses material nonpublic information while acting within the scope of his or her authority. The definition is so broad in fact that it would cover even ordinary course business communications. For example, a statement by an issuer's purchasing agent to a supplier as to a shortage in the supply of a raw material important to the issuer's operations could be covered by the Regulation since, depending on the circumstances, such a statement could be material.
By including directors in the definition of a person acting on behalf of an issuer, the Regulation would also cover communications by outside directors, the scope of whose authority does not normally extend to communications with the media, the analyst community or investors. Inside directors are already covered by the Regulation in their role as executive officers of an issuer. The reference to "directors" is therefore unnecessary and should not be included in the definition of a person acting on behalf of an issuer.
We believe that Regulation FD should not apply to communications by non-executive officers, other than persons making communications on behalf of the issuer to the media, the analyst community and/or investors. In other words, it should apply only to a person defined in proposed Rule 101(d)(2) as a "senior official" (which definition, for the reasons we suggest in the preceding paragraph, should not include directors) and only in the context of communications knowingly related to securities activities. Narrowing the application of the Regulation in this manner would focus selective disclosure regulation on your intended target (communications with analysts and investors) without interfering with ordinary course business transactions.
V. Loss of Eligibility for Incorporation by Reference and Rule 144
Under proposed Rule 101(e), "public disclosure" must be made by filing a Form 8-K (or a Form 6-K, in the case of a foreign private issuer), unless the issuer instead disseminates the information by press release or another method that provides broad public access. The availability of short-form and shelf registration under the Securities Act of 1933 (the "Securities Act") on Form S-3 or F-3 is conditioned on the timely filing of Exchange Act reports during the preceding twelve months. These two provisions might be read together to the effect that an issuer that fails to comply with Regulation FD would be disqualified from short-form and shelf registration. Further, Forms S-3 and F-3 do not provide that such a disqualification can be cured. As a result, public disclosure of information after the date required by Regulation FD would not restore the availability of those forms to the issuer. Even in the case of a non-intentional selective disclosure, an issuer could therefore be disqualified from using short-form and shelf registration for up to twelve months.
Under Rule 144(c), the filing of all reports required to have been filed under the Exchange Act during the preceding twelve months is a condition to the eligibility of an issuer's securities for sales pursuant to Rule 144. Although Rule 144(c) does not explicitly require that all such reports have been filed on a timely basis, the condition of having filed all "required" reports could be interpreted as including an element of timeliness. The failure to comply with Regulation FD's timing requirements would thereby raise doubts as to the availability of Rule 144.
In either case described above, we believe that the consequences of a failure to comply with Regulation FD would be too draconian. We therefore encourage you to clarify that violations of Regulation FD would not result in loss of eligibility for short-form and shelf registration or Rule 144.
VI. Public Offerings
Regulation FD would have a number of significant impacts in the context of registered public offerings.
A. Rule 181 Safe Harbor
Proposed Rule 181 would provide a safe harbor from Section 5(b)(1) of the Securities Act such that public disclosures made pursuant to and in compliance with Regulation FD would not be required to satisfy the prospectus requirements of Section 10 of the Securities Act. You have asked in the Release whether the proposed Rule should apply only to non-intentional disclosures. We do not believe that Rule 181 should be modified in this manner. We understand your concern that the safe harbor could be subject to abuse. We believe, however, that the potential for antifraud liability will serve as a sufficient deterrent to any such abuse and will also make unnecessary your alternative suggestion that the information be required to be included in the registration statement.
You have chosen not to provide a safe harbor in proposed Rule 181 for pre-filing communications that could constitute an illegal offer under Section 5(c) of the Securities Act. We believe this is a mistake. Requiring companies to make public disclosure in circumstances in which such disclosure would force them to remain out of the capital markets would generally constitute a disproportionate penalty for selective disclosure, particularly because the imprecise nature of the materiality definition makes it difficult to draw a bright line between intentional and unintentional conduct. We believe again that antifraud liability is a sufficient deterrent to abusive activity.
B. Roadshows and Initial Public Offerings
Regulation FD would apply to roadshow presentations made in connection with public offerings. We understand that you are currently reviewing issues arising in connection with roadshows more generally and are considering proposed rules or interpretive guidance based on that review. We believe any regulations applying to roadshows should be considered in connection with that broader undertaking, after you have gathered information about roadshows more generally and considered the issues raised by roadshows as a whole.
The proposed Regulation would not apply to statements made in connection with initial public offerings by issuers. We agree with this approach. Regulation FD is intended to address availability of information to the marketplace in respect of issuers whose securities are registered under the Exchange Act and therefore subject to secondary market trading. The Securities Act and the rules thereunder afford sufficient protections to investors in initial public offerings - both as to the information disclosed (as a result of Sections 11 and 12(a)(2) of the Securities Act) and the provision of information outside the prospectus (as a result of Section 5) - such that Regulation FD would add unnecessary complexity without significant benefits.
VII. Definition of Promptly
We believe that the definition of the term "promptly" contained in Rule 101(d) is too inflexible in the case of non-intentional disclosures. Requiring disclosure within 24 hours simply is not practical in all circumstances. In many cases of non-intentional selective disclosure, it will take time for a corporate official to notify the appropriate corporate officers, contact counsel and investigate and evaluate the matter after discovering that material nonpublic information has been selectively disclosed. In addition, based on when the disclosure is discovered to have occurred, some of these activities may have to be undertaken on a weekend or holiday when people are difficult to contact, press outlets are not open or fully operational, and the EDGAR system does not accept filings. We therefore recommend that you extend the timing requirement in the definition of "promptly" to at least 72 hours.
VIII. Form 8-K Requirements
You have asked in the Release whether a delayed filing on Form 8-K should be required if other methods of public disclosure are used pursuant to proposed Rule 101(e). We believe such an approach would be unduly cumbersome and would not provide significant additional benefits. Information disseminated through major news services provides disclosure to the public that can be accessed via Internet searches, trade publications and other periodicals. Requiring a Form 8-K to be filed on a delayed basis would not provide better disclosure, since the market will have already digested the information previously disclosed.
The Release includes a proposal to add a new Item 10 to Form 8-K for disclosures made pursuant to Regulation FD. We do not believe this change to Form 8-K would be necessary or helpful. The purpose of Regulation FD is to require issuers to make public disclosure of material nonpublic information. Its purpose should not be to require issuers to determine for investors whether an item of information is in fact material. That determination is best left for each investor to make for himself or herself. We instead believe that any disclosures made under Regulation FD on Form 8-K should be made pursuant to Item 5, which should be amended to provide for disclosures made pursuant to Regulation FD.
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We thank you for the opportunity to submit this comment letter. We would be happy to discuss with you any of the comments described above or any other matters you feel would be helpful in your review of the proposal. Please do not hesitate to contact Leslie N. Silverman or Alan L. Beller in New York (212-225-2000) or Edward F. Greene in London (44-171-614-2200) if you would like to discuss these matters further.
Very truly yours,
CLEARY, GOTTLIEB, STEEN & HAMILTON
1 SEC Release Nos. 33-7787; 34-42259; IC-24209 (Dec. 20, 1999) (the "Release").
2 Dirks v. SEC, 463 U.S. 646 (1983); Chiarella v. United States, 445 U.S. 222 (1980).
3 See SEC Release No. SAB 99 (Aug. 12, 1999) ("SAB 99").
4 See Basic v. Levinson, 485 U.S. 224, 231 (1988); TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976); SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1977).
5 SEC Release Nos. 33-7745; 34-41936; International Series Release No. 1205 (Sep. 28, 1999).